A RESEARCH REPORT FROM STOCKHOLM INSTITUTE FOR F INANCIAL RESEARCH

How Do Legal Differences and Learning Affect

Financial Contracts?

STEVEN N. KAPLAN

FREDERIC MARTEL

PER STRÖMBERG

NO 28 — SEPTEMBER 2004

Stockholm Institute for Financial Research (SIFR) is a private and independent non-profitorganization established at the initiative of members of the financial industry and actorsfrom the academic arena. SIFR was launched in January 2001 and is situated in the centerof Stockholm. Magnus Dahlquist serves as director of the Institute. The mission of SIFR

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SIFR also gratefully acknowledges research grants received from Bankforskningsinstitutet,Foreningsbankens Forskningsstiftelse, Jan Wallanders och Tom Hedelius Stiftelse, Riks-bankens Jubileumsfond, and Torsten och Ragnar Soderbergs stiftelser.

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How Do Legal Differences and LearningAffect Financial Contracts?

Steven N. Kaplan, Frederic Martel, and Per Stromberg

How Do Legal Differences and Learning Affect Financial Contracts?

by

Steven N. Kaplan*, Frederic Martel** and Per Strömberg*

First Draft: November 2003 This Draft: June 2004

Abstract

We analyze venture capital (VC) investments in twenty-three non-U.S. countries and compare them to U.S. VC investments. We describe how the contracts allocate cash flow, board, liquidation, and other control rights. In univariate analyses, contracts differ across legal regimes. However, more experienced VCs implement U.S.-style contracts regardless of legal regime. In most specifications, legal regime becomes insignificant controlling for VC sophistication. VCs who use U.S.-style contracts fail significantly less often. The results suggest that U.S. style contracts are efficient across a wide range of legal regimes. The evolution of contracts is consistent with financial contracting theories and costly learning.

G24: Investment banking; Venture Capital; Brokerage G32: Financing policy; Capital and ownership structure

* University of Chicago Graduate School of Business and **University of Lausanne IMD and UBS Global Asset Management. This research has been supported by the Kauffman Foundation, by the Lynde and Harry Bradley Foundation and the Olin Foundation through grants to the Center for the Study of the Economy and the State, and by the Center For Research in Security Prices. Ola Bengtsson, Alejandro Hajdenberg, Jonas Lindström, and Dali Ma provided excellent research assistance. We are grateful to the venture capital partnerships for providing data. We have received useful comments from Ulf Axelson, Jim Brander, Ron Giammarino, Luigi Guiso, Yael Hochberg, Anil Kashyap, Josh Lerner, Jay Ritter, Antoinette Schoar, Franco Wong, Lucy White, Luigi Zingales and seminar participants at the Bundesbank, Duke, the Federal Reserve Board of Governors, Harvard, Kauffman Foundation, MIT, NYU, the SIFR Conference on Venture Capital, SUNY Binghamton, the University of British Columbia, and the University of Chicago GSB and Law School. Contact information: Steven Kaplan, Per Strömberg: University of Chicago Graduate School of Business, 1101 East 58th Street, Chicago, IL 60637; e-mail: skaplan@uchicago.edu,per.stromberg@gsb.uchicago.edu. Frederic Martel: UBS Global Asset Management, Gessnerallee 3-5, CH-8005 Zurich; IMD; and University of Lausanne; e-mail: frederic.martel@ubs.com.

1. Introduction

Financial contracting plays an important role in aligning incentives and mitigating agency

conflicts between investors and entrepreneurs, thus allowing new ventures to obtain financing.1

Studies of U.S. venture capital (VC) investing, such as Sahlman (1990) and Kaplan and

Strömberg (2003 and 2004), show that investor contracts carefully allocate cash flow rights,

liquidation rights, and control rights between the entrepreneur and the VC investor in order to

mitigate agency conflicts. Kaplan and Stromberg (2003 and 2004) also show that the

characteristics of U.S. VC contracts correspond well to the optimal contracts derived by financial

contracting theories such as Aghion and Bolton (1992), Dessein (forthcoming), and Dewatripont

and Tirole (1994).

At the same time, the large and growing literature in law and finance finds that legal and

institutional differences among countries appear to be important for the development and nature

of financial markets, and also for economic growth.2 The ability to design investments and

financial contracts is potentially dependent on various elements of the institutional environment

– the nature of corporate and contract law, the quality of legal enforcement, accounting systems,

tax regulations, financial markets, etc. If the institutional environment affects the types of

contracts that can be written, this could change the types of contracts that are optimal.

This raises the question of whether the financial contracts observed in the U.S. are

optimal in other institutional environments. Theories of financial contracting would suggest yes

(because they assume property rights are enforced and little else). Alternatively, sufficiently

great institutional differences might lead to a negative answer. In this paper, we address this

1 See Hart (2001). 2 See King and Levine (1993), Laporta et al. (1997, 1998, and 2000), and Rajan and Zingales (2003).

2

question by studying VC investments across different institutional environments – 145

investments in 107 companies in 23 countries by 70 different lead VCs.

First, we describe how the contracts allocate cash flow, board, liquidation, and other

control rights. In univariate analyses, the contracts differ significantly across legal regimes.

While convertible preferred is the most commonly used security, it is used much less frequently

outside the U.S.; at the same time, ordinary common stock is used more frequently. Partly as a

result, VCs investing outside the U.S. deals have weaker control, liquidation and exit rights.

Non-U.S. investments also are less likely to use contingencies – including milestones, vesting

provisions and anti-dilution rights – resulting in less high-powered cash flow incentives

compared to their US counterparts.

Next, we consider how the contracts vary across legal regimes. We find that the

contracts vary systematically across those regimes. In particular, investments in common law

countries are more likely to look like U.S. contracts while investments elsewhere are likely to

differ. Liquidation preferences, anti-dilution protections, vesting provisions and redemption

rights are more typical in common law countries while milestones are less common. These

results are similar to those found in Lerner and Schoar (2003) who study private equity

investments in developing countries.

In this part of the analysis, we also consider how well specific measures of the legal and

institutional environment (such as creditor protection, efficiency of the legal system, tax

treatment, etc.) explain the differences across legal regimes. The specific measures are not

consistently related to the contractual differences (in contrast to the legal regime variables).

Given the mixed results for institutional factors, we then consider the importance of

individual VC characteristics and experience. In examining the contracts, we find that some VC

firms implement U.S. contractual features across all the countries and institutional environments

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in which they invest. In univariate analyses, we find that larger VCs, more experienced VCs,

and VCs with more exposure to U.S. are significantly more likely to implement U.S. style

contractual terms. The results indicate that while it may not be easy or obvious how to adapt

contracts, with enough effort (or legal fees), VCs can learn to replicate most U.S.-style contracts.

The results so far lead us to compare the relative important of legal regime and VC

experience. We estimate the determinants of contracts using regressions that include both legal

regime variables and measures of VC experience or sophistication. In the presence of the VC

experience variables, legal regime and institutional differences are relatively less important. In

fact, the legal regime variables are not significant in most specifications.

The results on VC sophistication are consistent with the U.S. model and U.S. contracts

being optimal outside the U.S. However, the results also are consistent with more sophisticated

VCs imposing a style with which they are familiar, but is not necessarily optimal. We explore

this possibility by studying the survival of the 70 VCs represented as lead investors in our

sample. As of August 2003, 59 of the 70 are still active while 11 have not survived. We then

separate the VC funds depending on the securities they used when acting as lead investors. None

of the 37 funds that exclusively used convertible preferred (and U.S. style contracts) has failed.

In contrast, 34% of the 29 funds that exclusively used common stock (and non-U.S. style

contracts) have not survived. Said another way, of the 11 funds that have not survived, all but

one never used convertible preferred. The results persist in multivariate analyses where we

control for other VC and portfolio company characteristics. The survival results strongly

indicate that more successful funds use U.S. style contracts.

Overall, our results suggest that U.S. style contracts are optimal across a wide range of

legal regimes. This conclusion is in the spirit of Fama and Jensen (1983) who argue that

contractual features that survive are likely to be efficient. As noted earlier, the separate

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allocation of cash flow, control and liquidation rights found in U.S. style contracts is consistent

with / predicted by standard financial contracting theories. The fact that we find more variation

in non-U.S. contracts (than in the U.S. contracts) suggests the presence of fixed costs of learning.

Consistent with this, all of the funds that used both non-U.S. and U.S. style contracts at some

point, switched from non-U.S. to U.S. style during the sample period. Based on both survival

and learning effects, we would predict more convergence in contracts over time.

Ours is not the first paper to study VC contracts outside of the U.S.3 Unlike this paper,

however, most previous studies focus on a single country and do not compare contracts across

institutional environments. Also, most of the studies do not analyze the actual contracts, but,

instead, rely on survey evidence and self-reporting from VC firms. This is problematic because

the studies critically depend on the details of the survey design and template. For example, as

Kaplan and Strömberg (2003) demonstrate, securities with different names can implement

identical allocations of cash flow and control rights (such as convertible preferred vs. senior

common stock), while securities with the same name can differ substantially in their rights (e.g.

standard vs. participating preferred stock).

In contrast to earlier studies, but similar to ours, contemporaneous work by Lerner and

Schoar (2003) uses actual contracts in private equity investments in developing countries. We

view their sample and paper as an interesting complement to ours. They find similar results in

that contracts are significantly related to legal origin. While they do not focus on the

sophistication and learning effects that we consider, their results on legal origin are robust to

including a dummy variable for U.S. or U.K. based organization. There are at least three

3 See Bascha and Walz (2001) for Germany, Bengtsson and Lindström (2000) and Isaksson et al. (1999) for Sweden, Cumming (2000, 2001) for Canada, and Hege, Palomino, and Schwienbacher (2003) for Europe.

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possible explanations for the different result. First, legal differences may be more of a constraint

in developing countries (although we do not find such a result in the few developing country

investments in our sample). Second, they study primarily private equity investments in more

mature businesses rather than VC investments. It may be more difficult to contract around

existing contracts and governance mechanisms. Finally, their sample includes a substantial

percentage of transactions in which the investors obtain majority control, making separate

control and liquidation rights less important. In our conclusion, we discuss how our results

might be reconciled with those in Lerner and Schoar (2003).

Our paper also complements earlier work on global venture capital activity. In a cross-

country study, Jeng and Wells (2000) show that factors such as IPO activity, government policies

toward start-ups, and labor market rigidities help explain differences in aggregate venture capital

activity between countries. Similarly, Mayer, Schoors, and Yafeh (2001) argue that country

differences in the composition of investors who provide funds to VC firms (banks, insurance

companies, pension funds, private corporations) result in different VC portfolio characteristics

across countries with respect to stage, geography, and industry focus.

The paper proceeds as follows. In section 2, we discuss the sample. In section 3, we

present our univariate analyses of the sample contracts and consider the (univariate) relation of

those contracts to legal and institutional factors, as well as VC characteristics. In section 4, we

present our multivariate results. In section 5, we relate the contractual terms to VC survival. In

section 6, we conclude.

2. Sample

2.1 Description

We analyze 145 investments in 107 companies in 23 countries by 70 different lead VCs.

6

We obtained investments from two sources – directly from VCs whom we know who invest

outside the U.S. and indirectly from a limited partner (institutional investor) who invests in non-

U.S. VC partnerships. All of the VC partnerships were for profit, non-governmental entities.

For each company and for each financing round for the company, we asked the VC to

provide the (1) term sheet; (2) stock and security purchase agreements; (3) company’s business

plan; and (4) the VC’s internal analysis of the investment. The amount of information we

obtained differs across investments and the different VCs who provided info.

Table 1 presents summary information. Panel A organizes the observations by country

and legal origin, and reports the number of financing rounds, number of companies, number of

VCs, and country institutional characteristics. Investments from countries with common law,

French law, German law, and Scandinavian law origins are well-represented. In addition, we

have five investments from countries of socialist background. We also report the number of

companies that reincorporated from and to the different countries.

Panel B indicates that the sample is relatively recent; all but eight investment rounds were

completed after 1997. In the analysis that follows, we compare the contracts in these

investments to those in Kaplan and Stromberg (20003) who use a sample of U.S. investments

that is roughly two years older.

Panel C presents the industry distribution of the portfolio companies in our sample. The

greatest percentage of companies, 58%, is in software and internet. Just over 10% of the

companies are in each of hardware, telecommunications, and life sciences. The sample industry

distribution is qualitatively similar to that for U.S. VC investments over the same period.

Panel D provides additional information about the investments. We have the first VC

round for 89% of the companies and roughly 2/3 of the investments are early stage, meaning that

the companies are quite young and have a limited operating history. Finally, the average

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investment is between $6 and $7 million with a median of just over $3 million.

2.2 Sample selection issues

In this section, we discuss potential selection issues concerning our sample. Our

companies and financings are not a random sample in that we obtained the data from VC firms

with whom we have a direct or indirect relationship.

It is possible that we have a bias toward the better investments of a particular VC. We

think this is unlikely because the investments we obtained from the VCs we contacted directly

included their most recent deals while the investments we obtained with the limited partner’s

help were not selected by the VCs. Even if some performance bias exists, we do not think it is

likely to affect our results because we do not attempt to measure performance of individual

investments. Rather, we characterize what contracts look like across different countries.

The more serious potential bias is that we have selected the VC firms. It is possible that

the average VC in our sample is different from the average VC in the countries we study. If this

is so, then our sample averages may be inaccurate. However, there is, again, no reason to believe

that our results on cross-sectional differences across legal regimes and types of VCs are biased.

Nevertheless, we acknowledge that the sample is selected and it is difficult to know the

extent of any bias. We have discussed the more likely biases and do not believe there are any

obvious red flags.

3. Contract characteristics: Univariate analyses

In this section, we present univariate analyses of the sample contracts and consider the

(univariate) relation of those contracts to legal and institutional factors, as well as VC

characteristics.

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3.1. Non-U.S. versus U.S. financings

The first two columns of table 2 describe the contracts in our sample and compare them

to the U.S. contracts in Kaplan and Strömberg (2003). There is much more variation in the

types of securities used outside the U.S. Whereas over 95% of the U.S. financings employed

some type of convertible preferred stock, fewer than 54% of the non-U.S. financings employed

convertible preferred. Ordinary common stock is more typical outside the U.S., used in almost

28% of financings versus fewer than 1% in the U.S. 4 Financings outside the U.S. also make use

of senior common stock 14.5% of the time. Although called common stock, senior common

stock resembles convertible preferred in that it always has a liquidation preference senior to

ordinary common.

Kaplan and Strömberg (2003) show that VC financings separately allocate cash flow

rights, board rights, voting rights, liquidation rights, and other control rights. Panels B to E of

table 2 compare these rights in the non-U.S. sample to those in the U.S. sample.

Kaplan and Strömberg (2003) find that VCs use anti-dilution rights, contingencies or

milestones, and vesting in order to increase the sensitivity of the founder’s cash flow rights to

performance, consistent with principal-agent theories. Panel B compares incentive mechanisms

that affect founder cash flow rights. VCs investing outside the U.S. have a smaller fully diluted

ownership percentage than VCs in the U.S. (36.3% versus 46.7%). This difference is not driven

by investment round. We also find that the incentive mechanisms – anti-dilution rights (56% vs.

4 Cumming (2001) and Lerner and Schoar (2003) obtain qualitatively similar results, i.e., a lesser use of convertible preferred and a greater use of common stock.

9

94%), funding milestones (39% vs. 53%), and founder vesting (37% vs. 44%) – are all less

typical outside the U.S.

Kaplan and Strömberg (2003) also show that the allocation of liquidation rights is an

important feature of U.S. VC contracts. In the U.S., VC securities are almost always senior

(97% of financings) to common stock in liquidation, and for an amount equal to or greater than

the amount invested. The seniority of the VC claim is a standard prediction of many financial

contracting theories, such as classical moral hazard theories (Holmstrom (1979)), signaling and

screening theories (Ross (1977) and Diamond (1991)), as well as the stealing theories of debt

(Hart and Moore (1998)). Panel C indicates that VC liquidation preferences are smaller in non-

U.S. financings. In 34% of the non-U.S. financings, the VC security has a liquidation preference

less than the amount invested. It also is less common for non-U.S. financings to have a

liquidation preference that exceeds the amount invested (48% vs. 68%).

Panel D compares the VC’s ability to force the liquidation of its investment. Redemption

rights give the VCs the ability to put their shares back to the company at some future date. When

used, the rights typically provide bargaining power to force a sale. Redemption rights are

present in 72% of the U.S. financings and only 34% of the non-U.S. financings. VCs can obtain

similar bargaining power by including drag-along rights together with seniority.5 Drag-along

rights force founders to sell their shares if the VCs decide to sell the company. When drag-

along rights and other senior exit mechanisms are combined with redemption rights, we find that

the VCs can force an exit in almost 64% of the non-U.S. financings.

Consistent with control theories (Aghion and Bolton (1992) and Dessein (forthcoming)),

Kaplan and Strömberg (2003) show that U.S. contracts allocate substantial control rights such as

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board seats and voting rights to the VC. Panel E shows that VCs in non-U.S. financings are less

likely to obtain board control of the portfolio company (12% vs. 25%), despite obtaining a

similar percentage of board seats.

Overall, then, the first two columns of table 2 suggest that the VC contracts outside the

U.S. have weaker rights of all types than those in the U.S.

3.2 Relation to legal origin

A substantial literature studies how differences in legal origins and institutions affect

various aspects of financial market activity across countries.6 Countries with French law origins

and weaker outside investor protection tend to have smaller and less liquid capital markets, more

concentrated corporate ownership, lower corporate dividends, and lower valuations. Some

papers also have attempted to link such factors specifically to the extent of VC activity.7

The legal system may affect the design of financial contracts in such a way that certain

contractual provisions may be infeasible or more costly to enforce. In addition, the contracts

may need to incorporate new protective mechanisms to make up for the legal deficiencies.

We now consider how the non-U.S. contracts in our sample vary with the legal origin of the

country in which the portfolio company is located. The last five columns of table 2 classify the

non-U.S. contracts in our sample into one of five different legal regimes – common law, French

law, German law, Scandinavian law, and socialist background. Except for socialist background

with only five contracts, we have at least 26 contracts in the other four legal regimes. In our

discussion, we generally will not refer to the results for the socialist background countries

5 For an analysis of drag-along rights, see Chemla, Habib, and Ljungqvist (2003). 6 See Laporta et al. (1997, 1998, and 2000), Demirguc-Kunt and Maksimovic (1998).

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because of the small number of observations.

Table 2 shows that for most provisions, common law country contracts tend to resemble

U.S.-style contracts more than those in countries with other legal origins. Common law country

deals tend to make greater use of convertible preferred and less use of ordinary common stock

while Scandinavian law country deals tend to do the opposite. Common law country contracts

(1) include more anti-dilution protection; (2) make greater use of vesting provisions; (3) are more

likely to have a liquidation preference at least equal to the amount invested; (4) are more likely

to have some type of exit mechanism; and (5) are the least likely to keep the founder in control

of the board. The one sense in which common law country contracts are less like those in the

U.S. is that the common law country deals are the least likely to use milestones.

Overall, these results suggest that legal origins / legal regimes affect the nature and types

of contracts that are written. This is consistent with the evidence in the LaPorta et al. papers that

countries differ in their corporate law and in the ability to write and enforce contracts

3.3 Relation to legal, tax, and accounting institutions

The results in the previous section indicate that legal origins matter for contracts, but do

not indicate why. In this section, we consider whether eight specific measures of differences in

legal rules, tax rules, accounting rules, and market institutions drive those results.

First, we consider the rule of law index used by LaPorta et al. (1997). The index is a

measure of the quality of a country’s legal and enforcement system.8 The first column of table 3

indicates that U.S. style contracts are negatively correlated with the rule of law measure.

7 See Black and Gilson (1998), Jeng and Wells (2000), and Mayer, Schoors, and Yafeh (2001)

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Convertible preferred, anti-dilution rights, liquidation preferences, and exit provisions are more

common in countries with low rule of law. One might interpret this result as showing that U.S.

style contracts are more appropriate when rule of law is low. There are two caveats to this

interpretation. First, U.S. contracts make the highest use of control and liquidation provisions

despite the U.S. having the highest rule of law. Second, the results are largely driven by the fact

that non-U.S. contracts are more typical in Scandinavian countries that have a high rule of law.

Apart from the legal system, corporate governance also may be affected by a country’s

accounting system (see Bushman and Smith (2001)). This should be more important for

contingencies or milestones that use accounting-based performance measures. Under a less

reliable accounting system, such milestones might be less feasible, leading to fewer

contingencies. In the second column of table 3, we consider how the contracts in our sample

vary with the accounting standards of the company’s country using the measure of accounting

standards from LaPorta et al. (1997). The column indicates that the contracts are qualitatively

identical across countries with strong and poor accounting standards.

Third, contracts may be affected by the strength of a country’s bankruptcy laws and

creditor protection. We use the index of creditor protection calculated in LaPorta et al. (1997).

One might expect creditor protection to have an effect on liquidation rights. On the other hand,

the creditor protection index reflects the efficacy of bankruptcy laws which may not be relevant

for VC investments that consist largely of equity securities. Column 3 of table 3 indicates that

contracts in high creditor protection countries have greater liquidation rights and make greater

use of exit provisions. Again, the caveat to this result is that U.S. contracts have strong

8 We assume that this measure (and other various measures we use), calculated in LaPorta et al. (1997), are still valid for our slightly later sample period.

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liquidation rights, but the U.S. has the lowest creditor protection score.

Next, we consider differences in minority shareholder protection. We use the index of

shareholder protection calculated in LaPorta et al. (1997). To the extent that minority

shareholders are not protected, it may be more important for the VCs to get explicit control

rights. On the other hand, this measure reflects the protection of minority shareholders of

publicly traded companies and, therefore, may not be so relevant for investments in private

companies. Column four of table 3 indicates that there are no substantive differences across low

and high minority protection countries.

Fifth, we consider restrictions on the ability of corporations to buy back their own shares.

Such restrictions are potentially important in that they might make it more difficult to implement

redemption and vesting provisions that typically require the company to repurchase shares. We

distinguish between countries in which companies can or cannot repurchase more than ten

percent of their shares (See Sabri (2002)). Column five of table 3 indicates that differences in

repurchase rules are unrelated to the contract provisions in our sample.

Sixth, we consider the tax environment that firms face. One area where taxation

differences might play an important role in contract design is the tax treatment of equity-based

compensation (including employee stock options). The European Venture Capital Association

(see EVCA (2001)) argues that the heavy taxation of stock option grants in Europe hampers the

ability of investors to provide incentives to portfolio company management. The EVCA’s

lobbying activity has recently led several countries to change their tax rules for employee stock

options to more closely resemble the U.S. treatment.9

We distinguish between countries with favorable and unfavorable taxation of stock

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options. We code as unfavorable those tax regimes that tax stock option gains at vesting (rather

than at exercise or sale) or tax option gains at marginal tax rates that exceed 40%. We might

expect to see less incentive compensation and less use of vesting in countries with unfavorable

taxation. Column six of table 3 indicates that the only significant difference across favorable and

unfavorable tax regimes is the use of anti-dilution provisions that are not particularly related to

tax. Vesting provisions are more common in favorable tax regimes, but not significantly so.

We then consider the liquidity of the stock markets in the portfolio company countries.

Black and Gilson (1998) argue that an active venture capital market relies heavily on the VCs’

ability to exit their portfolio investments through a public offering. In support of this argument,

Jeng and Wells (2000) find that VC investing is higher in countries with greater numbers and

values of initial public offerings of stock (IPOs). We distinguish IPO activity by whether the

country had more than thirty IPOs in 1999.10 We might expect the strength of exit provisions to

be related to this measure. In column 7 of table 3, the only significant difference across IPO

activity is that ordinary common is more prevalent in countries with high IPO activity.

Finally, we consider a measure of the efficiency of the legal system. We use the ‘Lex

Mundi formalism score’ from Djankov et. al. (2002) that measures the amount of time it takes

the legal system to deal with collecting on a bounced check. One might expect that VCs would

require more control and liquidation rights in regimes with less efficient legal systems. There is

some modest support for this. Liquidation rights and exit provisions are somewhat stronger in

more formal (less efficient) legal systems.

Overall, then, the direct measures of legal, tax, and accounting institutions that we have

9 Also, see Keuschnigg and Nielsen (2002) for a discussion of the impact of capital gains taxation on VC activity.

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explored are moderately successful although not uniformly so in explaining the previous results

on the relation of the contracts to legal origin.

3.4 Implementation of U.S. style contracts outside the U.S.

The modest results in the previous section suggest that legal, tax, and institutional

differences are only part of the story in explaining the observed distribution of contracts. In this

section, we obtain support for this conjecture by finding that some VCs implement U.S. style

contracts in all of the countries in which they invest. Table 4 summarizes this discussion.

First, even if convertible preferred stock is disfavored in corporate law, it is generally

possible to use senior common stock or combinations of common and non-convertible preferred

stock or debt to mimic the control and liquidation rights of convertible preferred.

Second, even if the legal regime makes it difficult to impose standard anti-dilution

provisions, it is generally possible to mimic those provisions using warrants that are exercisable

conditional on a subsequent financing at a lower valuation.

Third, even if vesting and other contingencies are hampered by unfavorable tax laws, it is

generally possible to use put options on the entrepreneur’s stock that are exercisable by the VC if

the entrepreneur leaves or misbehaves. In countries where additional equity for the entrepreneur

is taxed as compensation, it is possible to provide contingent equity by making the valuation or

financing contingent rather than the entrepreneur’s equity stake.

Fourth, it seems unlikely that legal differences could explain the absence of liquidation

preference. VCs can use seniority clauses in all of the countries in our sample.

10 While this is admittedly a coarse measure of IPO activity, our results are qualitatively identical using other measures, including the value of IPOs and both the number and value normalized by population or GDP.

16

Fifth, even if redemption rights are infeasible due to restrictions on a company buying

back its own stock, the VC can mimic these rights by combining a senior claim with drag-along

rights. This effectively gives the VC the right to liquidate because drag-along rights force all

shareholders to sell when the senior claimant decides to sell even if the senior claimant gets all or

most of the proceeds.

Sixth, if the local legal, tax, and institutional environment simply gets too restrictive, it is

generally possible to reincorporate the company in a country that is less restrictive. As column 3

of table 1 shows, 21% of the companies in our sample do reincorporate in another country.

There is a net flow of companies from countries of German and Scandinavian legal origin to

countries of common law origin.

These six examples indicate that while it may not be easy or obvious how to adapt a

particular contract, with enough effort and legal expertise, it appears possible to replicate most

U.S. style contractual mechanisms elsewhere.

3.5 Relation to VC experience and sophistication

The previous section describes how some VCs are able to get around institutional

constraints to implement U.S. style contracts. In this section, we examine the characteristics of

those VCs who do so. For each financing, we identify the lead VC as the VC who invests the

greatest amount in that financing. The lead VC typically plays the greatest role in negotiating

the contract with the entrepreneur.

In our analysis, we attempt to distinguish among the lead VCs by experience and

sophistication using three different variables. First, we distinguish between smaller and larger

VCs, using a breakpoint of (the sample median of) $200 million under management. Second, we

distinguish between younger and older VC firms, using a breakpoint of (the sample median age

17

of) four years. Third, we classify VCs according to their familiarity with the U.S. 21 financings

were led by VCs based in the U.S.; 87 financings were led by VCs who had previously

syndicated (or invested) with U.S. VCs; and 37 financings were led by VCs with no U.S.

experience. We determined if the VC had U.S. experience by examining the Venture Economics

financing database, the VentureOne financing database, and the individual VC websites.

Table 5 indicates that U.S. style provisions are positively and significantly correlated

with all three VC experience variables. Larger and older VCs, and VCs with U.S. experience are

all more likely to use convertible or participating preferred, stronger liquidation preferences, and

stronger exit provisions. Larger and older VCs own a larger percentage of fully diluted equity.

Older VCs and VCs with U.S. experience also use more time vesting, have stronger anti-dilution

protection, and are less likely to leave the founder with board control. It is only in the use of

milestones where there are no clear differences across VC experience.

The strong results for VC experience contrast with the modest results for legal, tax, and

accounting institutions. The multivariate analysis in section 4 will address the relative

importance of these factors.

3.6 Relation to financing round characteristics

It also is possible that the contractual characteristics vary with other characteristics of the

financing round. Accordingly, our final univariate analysis considers how contractual

characteristics vary with the size of the investment, whether the investment is the first by a VC,

and the age of the portfolio company.

Column 1 of table 6 shows that larger financing rounds (greater than $3 million) tend to

use more U.S. style contracts. Larger rounds are less likely to use ordinary common, have

stronger liquidation preferences, stronger exit provisions, and more VC board control. Not

18

surprisingly, larger rounds also are associated with greater VC percentage ownership.

Column 2 of table 6 indicates that subsequent VC rounds also make somewhat greater

use of U.S. style contracts. Subsequent VC rounds are less likely to use ordinary common, have

marginally stronger liquidation preferences, and more VC board control. VC percentage

ownership also increases in later rounds.

Finally, column 3 of table 6 shows that younger portfolio companies are somewhat more

likely to have U.S. style contracts. They are more likely to use convertible preferred, have

stronger liquidation preferences and stronger exit provisions.

4. Multivariate results

At this point, we have found that VC contracts are related to a country’s legal origin and

to measures of VC experience or sophistication. The contracts also are related to deal

characteristics and legal, accounting and institutional features. In this section, we assess the

relative importance of these different variables using multiple regression analyses.

In the first set of regressions, the dependent variable is an index of U.S. style terms. We

form the index as the sum of dummy variables for the presence of vesting, milestones, anti-

dilution rights, liquidation preference (at least equal to investment), redemption rights, and (non-

founder) board control. The index, therefore, varies from zero to six. We estimate the models

using Poisson regressions. In the second set of regressions, we estimate models using dummy

variables for the individual measures of cash flow, liquidation and control rights.

The regressions include independent variables that measure legal regime and VC

experience. Most of the regressions measure legal origin as a dummy variable equal to one if the

portfolio company is in a country with a common law legal origin. We also estimate some

regressions using the indices for legal formalism (Lex Mundi), accounting standards, creditor

19

protection, minority protection, and the dummy for option taxation.11 All of the regressions

include a dummy variable for whether the VC is U.S. based. The regressions also include an

additional VC experience variable: non-U.S. VC who has syndicated (invested) with a U.S. VC,

the VC age at the time of the financing, or the logarithm of VC funds under management.

All of the regressions control for the portfolio company age and if the financing is the

first VC round. Some of the regressions include controls for industry (software and Internet,

hardware, telecom, and life science), year of investment, deal size and if the portfolio company

reincorporated from its home country to a different one. All standard errors are clustered by lead

VC to avoid overweighting VCs with more observations. We obtain (but do not present)

statistically similar results when we cluster by year or industry.

Panel A of table 7 presents the Poisson regressions for our index. The regressions show

that the VC experience variables dominate the legal, accounting and institutional variables. The

VC experience variables, particularly VC based in the U.S. and non-U.S. VC with U.S. V.C.

syndication experience, are significant in every specification. In contrast, the legal regime,

accounting and institutional variables are not significant in any specification.

The economic magnitudes of the VC experience variables are also substantial. For

example, non-U.S. VCs who have syndicated with U.S. VCs include almost two additional U.S.

style provisions in their financings. This compares to coefficients (marginal effects) of 0.0 to

0.46 for the common law dummy variable that are never significant.

Some of the control variables also are significant. Younger portfolio companies are less

likely to use U.S. style provisions, while larger deals are more likely to include such

11 The reported regressions do not include share repurchase restrictions or IPO activity. When these variables are included, they are never significant.

20

provisions.12 In the last regression in panel A, first VC financings are associated with

significantly fewer (-0.56) U.S. style provisions. At the same time, portfolio companies

receiving their first VC financing in 2001 use significantly more (1.33) U.S. style provisions than

those receiving their first VC financing earlier. This is consistent with the overall VC market

converging toward U.S. style contracts over time.

In panels B and C of table 7, we estimate probit and ordered probit regressions using

dependent variables that measure the individual provisions: (i) whether the round uses

convertible or participating preferred;13 (ii) whether the round uses founder vesting; (iii) whether

the round uses milestones; (iv) whether the round uses anti-dilution protection; (v) whether the

liquidation preference is less than, equal to, or greater than the amount invested; (vi) whether the

round uses redemption rights; and (vii) whether the founder has control, shares control, or does

not have control of the board.

In panel B of table 7, we estimate the regressions with the common law dummy and the

VC experience variables. Again, the regressions strongly suggest that VC experience dominates

the effect of legal origin. The common law dummy is significant only for the use of anti-dilution

provisions. In contrast, both (1) VC based in the U.S. and (2) non-U.S. VC with U.S.

syndication experience are individually significant in all but one specification. One of the two is

significant in every specification. The reported marginal effects of the VC experience variables

are also economically larger than those for the common law variable.

Panel C of table 7 uses the more detailed legal, accounting and tax variables. We lose

some observations because we do not have the relevant indices for all of the countries in our

12 In most of the regressions, we do not control for deal size because it is arguably endogenous with the contracts. 13 The results are qualitatively and quantitatively identical when we use a dummy for ordinary common stock.

21

sample. Again, the VC experience variables are economically and statistically significant in all

but one specification. Only in the milestone regression are they both insignificant. (None of the

other variables are significant in this regression.)

In contrast, the legal, accounting and tax variables are only occasionally successful in

explaining the use of U.S.-style contracts. In five of the seven regressions, none of the variables

is significant at better than the 5% level. Accounting standards are significantly related to time

vesting although not to milestones. Minority protection is negatively related to liquidation

preferences, while creditor protection is positively related.

Overall, then, table 7 shows that the VC experience variables consistently dominate the

legal, accounting and institutional variables in both economic and statistical significance.

5. The relation of contractual terms to VC survival.

The analysis so far suggests that more experienced VCs implement U.S. style contracts

across many different legal regimes. One interpretation of this result is that more experienced

VCs are superior investors who should use more efficient contracts. Under this interpretation,

U.S. style contracts are optimal or, at least, the most effective of available contracts. This

interpretation is consistent with Kaplan and Schoar (forthcoming) who find that more

experienced VCs outperform less experienced VCs.

Alternatively, one might interpret the results simply as finding that VCs use the contracts

with which they are familiar. Because the more experienced VCs are more familiar with U.S.

contracts, they use them regardless of whether they are optimal.

In this section, we attempt to distinguish between those two interpretations by looking at

the ex post performance of the lead VCs in our sample. If the first interpretation is accurate, then

the VCs who use U.S. style contracts should be more successful than those who do not. Under

22

the second interpretation, we would not expect to see a large difference.

There are seventy different lead VCs in our sample financings. Although we cannot

collect the ex post VC returns, we can observe whether the VC firms are still operating entities.

We used Venture Economics, VentureOne, and the VC firm websites to determine the current

status of the VC firms. Table 8 reports that as of August 2003, fifty-nine of the seventy lead

VCs were still active and independent while eleven had failed or had been acquired.14

In table 8, we classify the VCs according to whether they always used, sometimes used,

or never used convertible or participating preferred stock. The use of such securities is a simple

univariate measure of the use U.S. style contracts. In the multivariate analysis in table 9, we also

use the index of U.S. style provisions.

The results in table 8 are highly statistically significant. Of the twenty-nine VCs that

never used preferred stock, 34% (or ten) have not survived. Of the thirty-seven VCs that always

used preferred stock, none has failed. The four VCs who sometimes used preferred stock fall in

between with one of the four having not survived. Said another way, ten of the eleven VCs that

did not survive did not ever use preferred stock. It is also worth noting that the four VCs who

sometimes used preferred stock always switched to preferred stock from some other security.

The rest of table 8 separates VCs based in common law countries from VCs based in non-

common law countries. The outcomes for VCs in non-common law countries drive the results.

Still, the one failed VC firm in a common law country was one that never used preferred stock.

While suggestive, the univariate results may be driven by correlations between contracts

and VC or portfolio company characteristics. To address this possibility, we estimate probit

regressions of the relation of VC survival to VC contracts controlling for VC fund and portfolio

23

company characteristics.

In the regressions, the dependent variable equals one if the VC survived. We measure

contracting in two ways. First, we use a dummy variable equal to one if the VC always used

preferred stock. Second, we use the average value of the U.S. style contract index for the sample

deals in which the VC was the lead VC. As control variables, we include dummy variables for

whether the VC is an early stage investor (as a measure of risk)15, whether the VC is controlled

by a financial institution or other corporation, whether the VC is in a common law country, and

the (log of) VC funds under management.

In table 9, the contracting variables are significant in all specifications. The index

variable is smaller in magnitude and significance in the fourth specification. This may be

partially due to a smaller number of observations. The only non-contracting variable that is

significant is VC funds under management in the fourth regression (which is associated with an

increased likelihood of survival).

Tables 8 and 9 show that more successful VCs use U.S. style contracts. In the spirit of

Fama and Jensen (1983), one interpretation of this result is that U.S. style contracts are more

efficient: (1) VCs using U.S. style contracts are more likely to survive and; (2) to the extent that

VCs changed their contracting style, they moved to the U.S. style contracts.16

An alternative interpretation is that VCs who used U.S. style contracts did better ex post,

but may not have been expected to do better ex ante, particularly in light of the tech “crash” of

2000 to 2002. By this argument, U.S. style contracts provide better downside protection, but do

14 A VC firm is typically acquired only when the firm’s investments are not performing well. 15 We obtain similar results when we use the percentage of a VC’s sample deals that are first rounds and the average portfolio company age of the VC’s sample deals. 16 This interpretation is consistent with U.S. style contracts providing better outcomes, but does not prove causation.

24

less well when the portfolio companies succeed. We think this interpretation is unsatisfactory

for two reasons. First, the theories that focus on control and liquidation rights, e.g., Aghion and

Bolton (1992) and Hart and Moore (1998), predict that those rights will be most important in the

bad or downside states of the world. Second, we consider in table 10 whether the VCs in our

sample trade off downside protection for reduced upside and fail to find such a relation.

In table 10, we test for a negative relation between the use of U.S. style terms and

measures of VC upside. The first set of regressions uses the pre-money value of the financing

round as a dependent variable. The pre-money value is the implicit valuation of the

entrepreneur’s (pre-VC) equity in the financing round. If there is a trade off, the pre-money

value will be increasing in U.S. style terms. I.e., the VC gets more U.S. style terms, but gives a

higher valuation to the entrepreneur. The second set of regressions uses the percentage of equity

(cash flow rights) that the VC gets in the financing round. If there is a trade off, the VCs

percentage equity will be decreasing in U.S. style terms. If anything, the results in table 10

indicate that more U.S. style terms are associated with more VC upside, not less. These results

hold controlling for VC experience and other control variables.

6. Summary and conclusion

In this paper, we compare VC contracts in twenty-three other countries to those in the

U.S. We analyze how the contracts allocate cash flow, board, liquidation, and other control

rights. In univariate analyses, contracts differ across legal regimes. In particular, U.S. style

contracts are more typical in common law countries. However, there appear to be few

institutional impediments to implementing U.S.-style terms. More experienced VCs are able to

implement U.S.-style contracts regardless of legal regime. In multivariate specifications,

measures of VC experience are more influential than legal regime or other legal, accounting, and

25

institutional variables. Finally, we consider the subsequent survival rate of the lead VCs in our

sample. VCs who use U.S.-style contracts are substantially and significantly less likely to fail.

Furthermore, the VCs who switched styles all moved from non-U.S. to U.S. style contracts.

We think the most plausible interpretation of our results is as follows. The contracts in

the U.S. have developed over several business cycles and are effective. The results in Kaplan

and Strömberg (2003) suggest that many elements of these U.S. contracts are consistent with the

predictions of optimal contracting theories. Venture capital investing outside of the U.S. is

relatively more recent and the legal rules are different. Learning about optimal or effective

contracts takes time and effort. Even in cases where VCs would like to implement U.S. style

contracts, it may not be costless to do so. If contracts are important for VC success, VCs using

efficient contracts will be more likely to survive and surviving VCs will be more likely to switch

to more efficient contracts. Furthermore, one might expect the evolution to accelerate in periods

of high volatility such as the tech crash after 2000. This interpretation is supported by the

survival results, the switching results, and the finding that first VC financings at the end our

sample use significantly more U.S. style provisions.

This interpretation also is suggested by our personal experience. When one of the co-

authors collected the data in 2000, he asked one of the VCs why the VC did not use U.S. style

contracts. The VC responded that he “did not think it mattered.” Two years later, in early 2002,

when the technology market was depressed, the co-author met the VC again. The VC

complained that he wanted to exert control in or force a sale of several of his portfolio company

investments, but was unable to do so. The VC acknowledged that the contracts did matter. A

year later, in 2003, the VC was out of business. From talking to VCs and lawyers, it is our

understanding that in 2004 most VC deals in that country use U.S. style contacts.

We believe the results have implications for the law and finance literature. The intuitions

26

and predictions of financial contracting theories appear to be valid across different institutional

and legal regimes. Based on this, we would expect more convergence toward U.S. style

contracts in the future. The results also suggest that it is beneficial for less experienced, local

investors to syndicate with and learn from more experienced, multinational investors.

One caveat to our results and predictions is that they are based on start-ups largely in

developed countries. There are two forces that may favor convergence for these types of firms.

First, enforcement of laws is generally not a major problem in most of the countries we study.

Second, it may be easier to write desirable contracts for new businesses than for existing ones.

The somewhat different results in Lerner and Schoar (2003) for private equity investments in

developing countries suggest that either or both of these forces may be important.

In fact, our results in conjunction with those of Lerner and Schoar (2003) are consistent

with the findings and conjectures in Acemoglu and Johnson (2003). Our results suggest that

sophisticated investors contract around existing contracting institutions to implement similar

(optimal) contracts for (i) start-ups located in countries in which property rights are enforced;

and (ii) for start-ups in developing countries with poor property right enforcement that are able to

reincorporate in countries in which property rights are enforced. It may be more difficult for

more mature companies in developing countries to incorporate elsewhere.17

17 Qian and Strahan (2004) study a sample of international bank loans and draw similar conclusions.

27

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Table 1

Summary Information

Summary information for 145 investments in 107 portfolio companies from 18 countries by 69 different lead VCs between 1992 and 2001. ‘ffective tax rate on option gains’ includes social security tax, when applicable, and is calculated based on Ernst & Young (2000a,b), using rules applicable on 1/1/2000. Information on legal origin, ‘Rule of law’, ‘Accounting standards’, ‘Creditor protection’, and ‘Minority protection’ (‘Anti-director rights’) are from LaPorta at al (1997). Number of IPOs’ is theaverage number of IPOs in the country 1999 and 2000 from FIBV (www.fibv.com). Data on share repurchase legislation is taken from Sabri (2002). ‘Share repurchases unrestricted’ refers to countries where corporations are allowed to buy back more than 10% of their shares. ‘Lex Mundi formalism score’ is a measure of procedural formalism in connection with collecting a bounced check, taken from Djankov et al (2002). ‘% First round inv.’ is the fraction of first round VC investments and ‘% Early stage deals’ are the fraction of seed and start-up investments in the sample. ‘Firm age’ is measured at the time of the investment round. ‘Financing committed’ is the aggregate amount of VC financing committed in the round.

A.: Portfolio company location and country data

Company’s country of operations

No. of. fin. rounds

No. of portf. comp’ located

No. of comp’s reincorp from / to

No. of leadVCs

Rule of law

Accountstd1990

Eff. tax on options gains

No. IPOs avg.99- 00

Creditor protect. score

Minor. prrotectscore

LexMundi formal-ism score

Share repos unres-tricted.

US 0 0 0 / 10 13 10 71 0.40 847 1 5 2.60 Yes. Hong Kong 1 1 0 / 0 0 8.22 69 0.15 64 4 5 0.73 Yes. India 4 4 1 / 0 2 4.17 57 0 52 4 5 3.34 Yes. Ireland 7 3 0 / 0 1 7.8 . 0.44 6 1 4 2.63 No. Israel 15 7 3 / 0 4 4.82 64 0 28 4 3 3.30 No. Singapore 2 1 0 / 0 1 8.57 78 0.28 70 4 4 2.50 Yes. UK 10 9 1 / 2 9 8.57 78 0 293 4 5 2.58 Yes. Common law 39 25 5 / 151 30 Belgium 5 4 0 / 0 3 10 61 0 18 2 0 2.73 No. France 13 11 3 / 0 4 8.98 69 0.40 78 0 3 3.23 No. Greece 2 2 2 / 0 1 6.18 55 . 45 1 2 3.99 No. Luxembourg 1 1 0 / 1 0 10 . 0.53 16 . . 3.56 . Netherlands 5 2 0 / 5 2 10 64 0 18 2 2 3.07 No. French law 26 20 5 / 6 10 Austria 1 1 0 / 1 1 10 54 0.61 6 3 2 3.52 No. Germany 14 10 0 / 0 6 9.23 62 0.56 160 3 1 3.51 No. Korea 1 1 0 / 0 0 5.35 62 . 10 3 2 3.37 Yes. Switzerland 27 20 5 / 0 10 10 68 0 23 1 2 3.13 Yes. German law 43 32 5 / 1 17 Denmark 3 2 1 / 0 2 10 62 0.63 7 3 2 2.55 No. Finland 2 2 1 / 0 0 10 77 . 24 1 3 3.14 No. Iceland 1 1 1 / 0 0 10 . 0.10 9 . . 4.13 No. Norway 3 1 1 / 0 1 10 74 0.63 18 2 4 2.95 No. Sweden 23 21 2 / 0 9 10 83 0.73 50 2 3 2.98 No. Scandin. law 32 27 5 / 0 12 Hungary 2 1 0 / 0 0 . . 0.61 7 . . 3.42 . Czech Rep. 1 1 1 / 0 0 . . . . . . 4.03 . China 2 1 1 / 0 0 . . . . . . 3.41 . Socialist background

5 3 2 / 0 0

Total 145 107 22 / 22

1 Includes one company reincorporated in Bahamas and two in Bermuda.

B.: Year of VC financing: Pre 1998 1998 1999 2000 2001 UnknownFirst financing round for co. 8 11 23 41 14 10 Financing rounds in sample 7 16 27 63 31 1

C. Industry Distribution of Companies

Software & Internet

Hardware & high-tech

Telecom Life Science Other/Unknown

Companies 62 13 12 12 8 Fin. rounds 88 18 14 17 8

D Other deal characteristics

% First round inv

Firm age, mean (med.)

% Early stage deals

Financing committed, $M

Earliest round we have for each company 88.9% 2.2 (1.0) 67.3% 6.2 (3.1) All financing rounds we have 66.9% 2.5 (1.0) 65.5% 6.8 (3.4) N 133 134 139 127

Table 2

VC contract characteristics across legal regimes

Contract characteristics for 145 investments in 107 portfolio companies from 18 countries by 69 different lead VCs between 1992 and 2001. Except where noted, the numbers in the table denotes the fraction of investments in the sample exhibiting a certain contract characteristics. U.S. sample statistics are taken from Kaplan and Strömberg (2003). ‘Legal regime’ is taken from LaPorta et al (1997). Contractual provisions are explained in the text. Contract characteristics differ significantly acrosssub-samples the: 1% ***; 5% **, and 10% * levels.

Contract characteristics: Compared to U.S. Across legal regime:

This. sample

US samp[e (K&S 2003) Common French German

Scandi-navian

Socialist background

A. Main VC security:

Convertible preferred 53.8% 95.2% 66.7% 53.8% 48.8% 37.5% 100.0%*

Ordinary common stock 27.6% 0.5% 7.7% 19.2% 37.2% 50.0% 0.0%**

Senior common stock 14.5% 1.0% 25.6% 19.2% 11.6% 3.1% 0.0% Convertible debt 2.0% 1.9% 0.0% 3.8% 0.0% 6,2% 0.0% Other security 2.0% 1.0% 0.0% 3.8% 2.3% 3.1% 0.0% Sample size 145 213 39 26 43 32 5

B. Residual cash flow rights and incentive mechanisms:VC equity %, milestones met and full vesting, mean (med.)

36.3% (34.0%)

46.7%

(47.3%)

37.3% (35.7%)

35.7% (33.0%)

37.0% (34.0%)

34.4% (34.2%)

35.0% (31.0%)

Sample size 130 212 37 25 39 24 5 Founder stock vests over time 37.20% 43.6% 50.0% 20.0% 31.6% 46.7% 50.0% Sample size 121 212 24 25 38 30 4 Equity or funding milestones 38.90% 53.0% 29.6% 41.7% 42.5% 36.7% 60.0% Sample size 126 212 27 24 40 30 5 VC anti-dilution protection 56.40% 94.60% 88.5% 73.9% 50.0% 25.8% 50.0%***

Sample size 213 26 23 40 31 4

C. Size of VC liquidation preference:Less than invested funds 34.10% 3.00% 10.7% 25.0% 39.0% 59.4% 0.0%**

Equal to invested funds 17.80% 28.70% 39.3% 8.3% 17.1% 9.4% 0.0%**

More than invested funds 48.10% 68.40% 50.0% 66.7% 43.9% 31.2% 100.0%**

Cumulative dividends 20.60% 43.8% 7.8% 20.8% 17.1% 29.0% 75.0% Participating preferred

(or equivalent) 34.60% 48.0% 48.2% 37.5% 29.3% 29.0% 25.0%

Other “booster” (e.g. 3x) 15.10% 2.4% 3.8% 20.8% 19.5% 6.4% 75.0% Sample size 129 213 28 24 41 32 4

D. VC exit provisions:VC has redemption rights 34.5% 71.8% 41.0% 34.6% 30.2% 28.1% 60.0% Other senior exit mechanism 50.0% - 66.7% 63.6% 45.7% 28.6% 75.0% No senior exit mechanism 36.6% 28.2% 25.6% 26.9% 39.5% 56.2% 20.0% Sample size 145 213 39 26 43 32 5

E. Board controlNo. board seats, mean (med) 5.7 (5.0) 6.0 (6.0) 6.0 (6.3) 5.8 (5.0) 4.8 (5.0) 5.7 (5.0) 6.5 (7.0)**

% VC board seats 37.0 (40.0) 41.4 (40.0) 32.0 (33.3) 40.4 (40.0) 42.2 (33.3) 34.3 (40.0) 38.6 (34.3)

Degree of board control: Founder controls board 27.6% 13.9% 18.0% 46.2% 18.6% 34.4% 40.0%

Neither / state-contingent 60.0% 60.7% 71.8% 42.3% 65.1% 56.2% 40.0% VC controls board 12.4% 25.4% 10.3% 11.5% 16.3% 9.4% 20.0%

Sample size 145 201 39 26 43 32 5

Ta

ble

3

VC

con

tract

s an

d o

ther

in

stit

uti

on

al

chara

cter

isti

cs

Contr

act

char

acte

rist

ics

for

145 i

nv

estm

ents

in

10

7 p

ort

foli

o c

om

pan

ies

fro

m 1

8 c

ou

ntr

ies

by

69

dif

fere

nt

lead

VC

s b

etw

een

19

92 a

nd

20

01

. ‘

Ru

le o

f la

w, H

igh

’ re

fers

to

th

e su

b-s

amp

le o

f in

ves

tmen

ts w

ith

a ‘

Ru

le o

f la

w’

ind

ex o

f 1

0. ‘

Acc

ou

nti

ng

sta

nd

ard

s, H

igh

’ re

fers

to t

he

sub

-sam

ple

of

inv

estm

ents

wit

h a

n ‘

Acc

ou

nti

ng

sta

nd

ard

s’ i

nd

ex o

f 6

9 o

r h

igh

er.

‘C

red

ito

r p

rote

ctio

n, H

igh

’ re

fers

to

th

e su

b-s

amp

le o

f in

ves

tmen

ts w

ith

a ‘

Cre

dit

or

pro

tect

ion

‘ in

dex

of

3 o

r h

igh

er. ‘

Min

ori

ty p

rote

ctio

n, H

igh’

refe

rs t

o t

he

sub-

sam

ple

of

inv

estm

ents

wit

h a

‘M

ino

rity

pro

tect

ion‘

index

of

3 o

r hig

her

. ‘F

avora

ble

opti

ons

tax’

refe

rs t

o t

he

sub-s

ample

of

inves

tmen

ts i

n c

ountr

ies

wher

e th

ere

is n

o t

ax o

n

emp

loy

ee s

tock

op

tio

ns

up

on

ex

erci

se.

‘S

har

e re

po

s u

nre

stri

cted

’ re

fers

to

th

e su

b-s

amp

le o

f in

ves

tmen

ts i

n c

ou

ntr

ies

wh

ere

corp

ora

tions

are

allo

wed

to b

uy b

ack m

ore

than

1

0%

of

thei

r sh

ares

. ‘

Per

cap

. V

C i

nv

est.

’ re

fers

to

th

e su

b-s

amp

le o

f in

ves

tmen

ts i

n c

ou

ntr

ies

wit

h V

C i

nv

estm

ent

in 1

99

9 a

bove

$41 p

er c

apit

a. ‘I

PO

act

ivit

y, H

igh’

refe

rs t

o

the

sub-s

ample

of

inves

tmen

ts i

n c

ountr

ies

wit

h m

ore

than

30 I

PO

’s p

er y

ear

on a

ver

age

1999-2

000.

‘L

ex M

undi

legal

form

alis

m h

igh’

refe

rs t

o t

he

sub-s

ample

of

inves

tmen

ts

in c

ou

ntr

ies

wit

h a

leg

al f

orm

alis

m s

core

above

3.

Con

trac

tual

pro

vis

ion

s ar

e si

gn

ific

antl

y d

iffe

ren

t ac

ross

sub

-sam

ple

s at

the:

1

% *

**

; 5

% *

*, an

d 1

0%

* l

evel

s. T

ests

fo

r d

egre

e o

f li

qu

idat

ion

pre

fere

nce

an

d d

egre

e of

boar

d c

ontr

ol

are

join

t ac

ross

th

e th

ree

deg

rees

of

liquid

atio

n p

refe

rence

/ b

oar

d c

ontr

ol,

usi

ng a

Kru

skal

-Wal

lis

test

. A

ll o

ther

te

sts

refe

r to

dif

fere

nce

s in

mea

ns

test

s, u

sin

g a

ran

k-s

um

tes

t.

Contr

act

char

acte

rist

ics:

R

ule

of

law

A

ccounti

ng

stan

dar

ds

Cre

dit

or

pro

tect

ion

M

ino

rity

P

rote

ctio

n

Sh

are

rep

os

un

rest

rict

ed

Fav

ora

ble

o

pti

on

s ta

x

IPO

act

ivit

y

Lex

Mu

ndi

legal

fo

rmal

ism

Hig

h

Low

H

igh

L

ow

L

ow

H

igh

L

ow

H

igh

Y

es

No

Y

es

No

L

ow

H

igh

L

ow

H

igh

A.

Mai

n V

C s

ecu

rity

:

Co

nv

erti

ble

pre

ferr

ed

43

.7

63

.5**

51

.5

55

.8

49

.4

60

.3

51

.7

55

.2

44

.4

56

.4

53

.7

53

.9

61

.6

45

.8*

42.6

6

0.4

**

Ord

inar

y c

om

mo

n

39.4

1

6.2

**

*

32.3

2

3.4

3

6.8

2

4.1

***

29

.3

26

.4

33

.3

26

.6

20

.9

33

.3*

20.6

3

4.7

*

33.3

2

4.2

S

enio

r co

mm

on

sto

ck

12.7

1

6.2

8

.8

19.5

*

8.1

1

3.8

***

17

.2

12

.6

22

.2

10

.6*

25.4

5

.1***

16.4

1

2.5

1

8.5

1

2.1

C

onv

erti

ble

deb

t 2

.8

1.3

4

.4

0.0

3

.5

0.0

0

.0

3.5

0

.0

3.2

0

.0

3.9

0

.0

4.2

3

.7

1.1

O

ther

sec

uri

ty

1.4

1

2.7

2

.9

1.3

2

.3

1.7

1

.7

2.3

0

.0

3.2

0

.0

3.9

1

.4

2.8

1

.8

2.2

S

amp

le s

ize

71

7

4

68

7

7

87

5

8

58

8

7

67

7

8

73

7

2

54

9

1

B.

Res

idual

cas

h f

low

rig

hts

and

ince

nti

ve

mec

han

ism

s:

VC

eq

uit

y %

3

8.1

3

4.2

3

6.7

3

6.0

3

5.8

3

7.0

3

5.6

3

6.8

3

6.3

3

6.5

3

6.8

3

5.8

3

7.6

3

5.0

3

4.7

3

7.2

N

o. o

f ob

s 6

9

61

5

8

72

7

6

54

5

3

77

4

1

83

6

3

67

6

5

65

4

5

85

F

ou

nd

er t

ime

ves

tin

g

38.8

3

5.2

4

2.1

3

2.8

3

5.4

4

0.5

2

8.8

4

3.5

4

6.2

3

2.5

4

1.8

3

3.3

3

7.9

3

6.5

4

5.4

3

2.5

N

o. o

f ob

s.

67

5

4

57

6

4

79

4

2

52

6

9

39

7

7

55

6

6

58

6

3

44

7

7

E

quit

y /

fundin

g

mil

esto

nes

3

5.8

4

2.4

4

1.0

3

6.9

3

7.0

4

2.2

4

1.5

3

7.0

4

3.9

3

4.2

3

3.9

4

2.9

3

9.3

3

8.5

3

4.0

4

1.8

No. o

f ob

s.

67

5

9

61

6

5

81

4

5

53

7

3

39

7

7

56

7

0

61

6

5

47

7

9

V

C a

nti

-dil

uti

on

p

rote

ctio

n

42.5

7

2.7

**

*

52.5

6

0.0

5

0.6

6

8.3

*

54.7

5

7.8

5

7.5

5

5.7

6

5.4

4

9.3

**

68.2

4

4.3

4

8.9

6

1.0

Sam

ple

siz

e 6

9

55

5

9

65

8

3

41

5

3

71

4

0

79

5

5

69

6

3

61

4

7

77

Ta

ble

3

VC

co

ntr

act

s a

nd

oth

er i

nst

itu

tion

al

cha

ract

eris

tics

, co

nti

nu

ed.

R

ule

of

law

A

ccounti

ng

stan

dar

ds

Cre

dit

or

pro

tect

ion

M

ino

rity

P

rote

ctio

n

Sh

are

rep

os

un

rest

rict

ed

Fav

ora

ble

o

pti

on

s ta

x

IPO

act

ivit

y

Lex

Mu

ndi

legal

fo

rmal

ism

Hig

h

Low

H

igh

L

ow

L

ow

H

igh

L

ow

H

igh

Y

es

No

Y

es

No

L

ow

H

igh

L

ow

H

igh

C.

Liq

uid

atio

n p

ref.

:

<

in

ves

ted

fu

nd

s 4

4.3

2

2.0

**

41.9

2

6.9

4

3.4

1

7.4

*

30.9

3

6.5

3

4.9

3

5.8

2

4.6

4

1.7

2

5.4

4

2.4

4

2.0

2

9.1

*

= i

nv

este

d f

un

ds

14

.3

22

.0**

8.1

2

6.9

1

0.8

3

0.4

*

18.2

1

7.6

2

7.9

1

3.6

3

1.6

6

.9

22.2

4

3.6

1

2.0

2

1.5

*

> i

nv

este

d f

un

ds

41

.4

55

.9**

50.0

4

6.3

4

5.8

5

2.2

*

50.9

4

5.9

3

7.2

5

0.6

4

3.9

5

1.4

5

2.4

4

3.9

4

6.0

4

9.3

*

Cu

mu

lati

ve

div

iden

ds

23.2

1

7.5

2

3.4

1

8.2

2

1.7

1

8.6

1

8.5

2

2.2

1

2.2

2

2.5

1

6.4

2

3.9

1

9.4

2

1.9

1

9.1

2

1.5

P

arti

cip

atin

g p

refe

rred

3

0.4

3

9.7

3

9.3

3

0.3

3

2.5

3

8.6

3

3.3

3

5.6

3

1.0

3

6.2

3

2.1

3

6.6

3

7.1

3

2.3

3

9.6

3

1.6

O

ther

(e.

g. 3

x

liq

uid

atio

n

pre

fere

nce

)

13.0

1

7.5

1

0.0

1

9.7

1

3.2

1

8.6

2

2.2

9

.7*

12.2

1

3.8

1

4.6

1

5.5

1

7.7

1

2.5

1

0.6

1

7.7

Sam

ple

siz

e 7

0

59

6

0

66

8

3

46

5

4

72

4

1

80

5

5

71

6

2

64

5

0

79

D. E

xit

pro

vis

ion

s:

VC

red

emp

tio

n r

igh

ts

23.9

4

4.6

**

*

33.8

3

5.1

2

6.4

4

6.6

**

32.8

3

5.6

3

5.1

3

1.1

3

1.3

3

7.2

3

5.6

3

3.3

2

5.9

3

9.6

*

Oth

er s

enio

r ex

it

41.9

6

0.4

*

41.1

5

4.2

4

3.8

6

2.2

*

55.3

4

6.0

5

1.4

4

7.1

5

2.9

4

7.5

5

1.8

4

8.2

4

8.7

5

0.7

N

o s

enio

r ex

it

46.5

2

7.0

**

41.2

3

2.5

4

6.0

2

2.4

**

*

32.8

3

9.1

3

5.6

3

8.3

3

2.8

3

9.7

3

2.9

4

0.3

4

4.4

3

1.9

S

amp

le s

ize

71

7

4

68

7

7

87

5

8

58

8

7

45

9

4

67

7

8

73

7

2

39

7

1

E

. B

oar

d c

on

tro

l

N

o.

seat

s, t

ota

l, m

ean

(med

) 5

.4

(5.0

) 6

.1

(6.0

) **

6.1

(6

.0)

5.2

(5

.0) *

**

5.7

(5

.0)

5.7

(6

.0)

5.0

(5

.0)

6.1

(6

.0) *

**

5.4

(5

.0)

6.1

(6

.0)

**

5.4

(5

.0)

5.9

(6

.0)

*

5.7

(5

.0)

5.7

(5

.5)

6.0

(6

.0)

5.4

(5

.0)

*

% V

C b

oar

d s

eats

, m

ean

(med

) 3

7.1

(4

0.0

) 3

7.5

(3

8.8

) 3

5.6

(3

8.8

) 3

9.1

(4

0.0

) 3

8.0

(4

0.0

) 3

5.7

(3

3.3

) 4

1.2

(4

0.0

) 3

4.9

(4

0.0

) 3

5.6

(3

3.3

) 3

8.0

(4

0.0

) 3

6.3

(3

3.3

) 3

8.1

(4

0.0

) 3

7.5

(4

0.0

) 3

7.0

(3

7.5

) 3

4.9

(3

3.3

) 3

9.7

(4

0.0

)

Deg

ree

of

bo

ard

co

ntr

ol:

Fou

nd

er c

on

trol

32.4

2

3.0

3

3.8

2

2.1

3

1.0

2

2.4

2

4.1

2

9.9

2

2.2

2

8.7

2

5.4

2

9.5

2

8.8

2

6.4

3

3.3

2

4.2

N

eith

er /

sta

te-c

on

t.

54.9

6

4.9

5

5.9

6

3.6

5

5.2

6

7.2

6

2.1

5

8.6

6

6.7

5

8.5

6

1.2

5

9.0

5

7.5

6

2.5

5

9.3

6

0.4

V

C c

on

tro

ls

12.7

1

2.2

1

0.3

1

4.3

1

3.8

1

0.3

1

3.8

1

1.5

1

1.1

1

2.8

1

3.4

1

1.5

1

3.7

1

1.1

7

.4

15.3

S

amp

le s

ize

71

7

4

68

7

7

87

5

8

58

8

7

45

9

4

67

7

8

73

7

2

54

9

1

Table 4

Implementation of U.S. style contracts outside the U.S.

U.S. contractual feature Purpose and potential institutional obstacles

Alternative implementation

Convertible preferred stock Purpose: Allocates cash-flow and control rights between VC and entrepreneur. Problem: Convertible preferred stock disfavored in corporate law.

Common + Straight preferred stock. Common + Zero-coupon debt. Senior common stock with liquidation preference. Convertible debt.

Anti-dilution rights (Full ratchet): Upon a subsequent financing at a valuation lower than the original financing, the conversion price of the original convertible preferred stock is adjusted downward to the issuance price of the dilutive financing. Written into the articles of incorporation.

Purpose: Protect VC from subsequent dilutive financing rounds.

Problem: Various, restrictions e.g. : Convertible preferred stock disfavored in corporate law; shareholder vote needed for adjustment to conversion price.

Anti-dilution warrants: Warrants attached to the VC’s stock can be exercised by an investor in case of a capital increase or in case of an issuance of stock to finance the acquisition of another company, given that the price per share involved is below the original subscription price. The number of shares to be acquired this way will be such that the resulting price obtained by the investors after these transactions is equal to the original subscription price.

Vesting Provisions: Company will have a repurchase option to buy back at cost a portion of the shares of common stock held by a certain shareholder (founder) if such shareholder's employment with the company ends before some specified date. A portion will be released each month from the repurchase option based upon continued employment.

Purpose: Make it costly for founder to leave firm prematurely. Increase pay-performance sensitivity.

Problem: Vesting of shares may be treated as income, and as a result vested shares are taxed at the ordinary income tax rate upon the vesting date.

“Good leaver” and “bad leaver” provisions: (example) “ ‘Good leavers’ (i.e founder employees voluntarily terminating their employment contract with the company) shall offer their shares in the company to the other shareholders at a price incorporating a considerable penalty. ‘Bad leavers’ (i.e. founders being terminated as a result of material breach by the founder employees of the applicable terms and conditions of their employment contract with the company) shall offer their shares to the other shareholders of the company at a price corresponding to the valuation of the last financing less 25%. Agreement will terminate upon an IPO or a sale of the company.”

Equity milestones: Upon company reaching a performance milestone, additional shares will be issued to founders.

Purpose: Increase pay-performance sensitivity. Problem: Granting shares to founders treated as income, and granted shares taxed at the ordinary income tax rate.

Contingent valuations: Upon company reaching a performance milestone, investors will put in additional funds in the company.

Redemption provisions: (example) At the election of the holders of a majority of the preferred, the Company shall redeem the outstanding preferred shares in two equal installments beginning on the fifth anniversary of the prior preferred closing date.

Puirpose: To be able to exit an unsuccessful investment.

Problem: Share repurchases restricted by corporate law.

Drag-along provision: After five years, if investors offer to sell their shares to a 3rd party, it may require all the other shareholders also to sell or dispose of their shares on a pro rata basis and on the same terms to the 3rd party. Other exit provision: If listing does not occur in five years, the parties agree that upon request of the majority of investors, the company shall instruct an investment bank to find a buyer for all of the company’s shares.

Table 5

VC contract characteristics and Lead VC experience

Contract characteristics for 145 investments in 107 portfolio companies from 18 countries by 69 different lead VCs between 1992 and 2001. The ‘Lead VC’ is defined as the VC committing the largest amount of funds in the syndicate in the current financing round. ‘VC from US’ is a dummy equal to one if the Lead VC investor is located in the United States. ‘Syndicated with U.S. VC’ is a dummy equal to one if the Lead VC investor is (1) not located in the United States, and (2) had either previously invested in a portfolio company located in the United States or co-invested with a U.S.-based VC at the time of the financing. ‘No US exp.’ is a dummy equal to one if both previous dummy variables are zero. Contractual provisions are significantly different across sub-samples at the: 1% ***; 5% **, and 10% * levels. Tests for degree of liquidation preferenceand degree of board control are joint across the three degrees of liquidation preference / board control, using a Kruskal-Wallistest. All other tests refer to differences in median tests, using a rank-sum test.

Lead VC funds under management

Lead VC age Lead VC degree of U.S. experience

>$200M <=$200M >=4 yrs <4 yrs VC from US

Syndicatedwith US VC

No US exp.

A. Main VC security:

Conv. / part. preferred 80.8% 26.4%*** 76.7% 30.6%*** 94.7% 62.1% 10.8%***

Ordinary common stock 13.7% 41.7%*** 16.4% 38.9%*** 0.0% 18.4% 64.9%***

Common w. liq. preference 4.1% 25.0%*** 2.7% 26.4%*** 0.0% 18.4% 13.5% Convertible debt 0.0% 4.2% 1.4% 2.8% 0.0% 0.0% 8.1% Other 1.4% 2.8% 2.7% 1.4% 5.4% 1.2% 2.7% Sample size 73 72 73 72 37 87 37 B. Residual cash flow rights and incentive mechanisms: VC equity % 40.8% 31.5%*** 39.7% 33.3%** 45.2% 35.6% 34.0%

No. of obs 67 63 61 69 17 80 31 Founder time vesting 35.20% 38.80% 50.9% 25.0%*** 66.7% 40.3% 18.8%**

Sample size 54 67 57 64 15 72 32 Equity / funding milestones 33.90% 43.30% 45.90% 32.30% 25.0% 48.0% 22.6%*

Sample size 59 67 61 65 16 77 31 VC anti-dilution protection 61.80% 52.20% 73.3% 40.6%*** 86.7% 67.6% 18.2%***

Sample size 55 69 60 64 15 74 33

C. Liquidation pref.: Less than invested funds 17.2% 47.9%*** 24.6% 42.6%*** 0.0% 22.4% 77.1%***

Equal to invested funds 5.2% 28.2%*** 9.8% 25.0%*** 18.8% 21.0% 11.4%***

More than invested funds 77.6% 23.9%*** 65.6% 32.4%*** 81.2% 56.6% 11.4%***

Cumulative dividends 32.1% 11.4%*** 31.7% 10.6%*** 25.0% 25.3% 9.1% Part. pref. (or equiv.) 57.9% 15.7%*** 45.0% 25.4%** 62.5% 42.1% 0.0%***

Other “booster” (e.g. 3x) 17.9% 12.9% 23.3% 7.6%** 12.5% 17.3% 12.1% Sample size 58 71 61 68 16 76 35 D. Exit provisions: VC has redemption rights 46.6% 22.2%*** 48.0% 20.8%*** 63.2% 35.6% 18.9%**

Other senior exit mechanism

55.1% 45.9% 48.8% 51.7% 33.3% 62.7% 24.1%***

No senior exit mechanism 24.7% 48.6%*** 30.1% 43.1% 21.0% 28.7% 64.9%***

Sample size 73 72 73 72 19 87 37 E. Board control

No. seats, total, mean (med) 5.9 (5.5) 5.5 (5.0) 6.1 (6.0) 5.3 (5.0) ** 6.2 (6.5) 5.6 (6.0) 5.6 (5.0) % VC board seats 40.9 (40.0) 34.0 (33.3)** 39.3 (40.0) 35.5 (33.3) 46.8 (42.9) 36.6 (33.3) 34.4 (31.0)**

Degree of board control: Founder controls board 21.90% 33.30% 19.2% 36.1%** 5.3% 26.4% 37.8%**

Neither / state-contingent 65.80% 54.20% 67.1% 52.8%** 63.2% 63.2% 54.0%**

VC controls board 12.30% 12.50% 13.7% 11.1%** 31.6% 10.3% 8.1%**

No. obs. 73 72 73 72 19 87 37

Table 6

VC contracts and deal characteristics

Contract characteristics for 145 investments in 107 portfolio companies from 18 countries by 69 different lead VCs between 1992 and 2001. ‘Funds committed’ is the total VC funds committed in the financing round, expressed in U.S. dollars. Country, deal and investor characteristics are significantly different at the: 1% ***; 5% **, and 10% * levels. Tests for degree of liquidation preference and degree of board control are joint across the three degrees of liquidation preference / board control,using a Kruskal-Wallis test. All other tests refer to differences in median tests, using a rank-sum test.

Funds committed First VC investment Firm age

A. Main VC security: >$3M <$3M First round Subs. round < 2 years >= 2 years

Conv. / part. preferred 68.2% 31.6%*** 44.9% 77.3%*** 61.0% 40.0%**

Ordinary common stock 21.6% 36.8%** 31.5% 11.4%** 23.2% 36.0% Common w. liq. preference 9.1% 22.8%** 18.0% 11.4% 11.6% 20.0% Convertible debt 0.0% 5.3% 3.4% 0.0% 2.1% 2.0% Other 1.1% 3.5% 2.3% 0.0% 2.1% 2.0% Number of observations 88 57 89 44 95 50 B. Residual cash flow rights and incentive mechanisms:

VC equity % 41.7% 28.7%*** 31.1% 48.2%*** 38.1% 32.1%*

Number of observations 76 54 82 42 90 40 Founder time vesting 40.0% 33.3% 39.0% 34.4% 42.1% 28.9% Number of observations 70 51 77 32 76 45 Equity / funding milestones 43.1% 33.3% 39.0% 29.0% 37.5% 41.3% Number of observations 72 54 77 38 80 46 VC anti-dilution protection 62.0% 49.1% 52.0% 69.4%* 56.4% 56.5% Number of observations 71 53 77 36 78 46

C. Liquidation pref.: Less than invested funds 26.7% 44.4%** 37.0% 16.7%* 29.3% 42.6%**

Equal to invested funds 16.0% 20.4%** 17.3% 22.2%* 15.8% 21.3%**

More than invested funds 57.3% 35.2%** 45.7% 61.1%* 54.9% 36.2%**

Cumulative dividends 23.6% 15.7% 22.5% 11.4% 24.4% 18.5% Part. preferred (or equiv.) 39.7% 27.8% 32.5% 44.4% 21.7% 42.0%**

Other “booster” (e.g. 3x) 19.4% 9.3% 15.0% 17.0% 9.9% 24.4%**

Sample size 75 54 81 36 82 47 D. Exit provisions: VC has redemption rights 43.2% 21.0%*** 32.6% 38.6% 34.7% 34.0% Other senior exit mechanism

51.6% 47.9% 47.9% 56.7% 55.1% 41.5%

No senior exit mechanism 30.7% 45.6%* 38.2% 29.6% 32.6% 44.0% Sample size 88 57 89 44 95 50 E. Board control

No. seats, total, mean (med) 6.0 (6.0) 5.2 (5.0) ** 5.5 (5.0) 5.9 (6.0) 5.8 (6.0) 5.5 (5.0) % VC board seats 40.2 (40.0) 33.5 (33.3)** 35.6 (33.3) 41.2 (40.0)** 32.7 (35.4) 39.8 (40.0)*

Degree of board control:

Founder controls board 14.8% 47.4%*** 32.6% 18.2%** 24.2% 34.0% Neither / state-contingent 70.4% 43.9%*** 59.6% 59.1%** 63.2% 54.0%

VC controls board 14.8% 8.8%*** 7.9% 22.7%** 12.6% 12.0% Sample size 88 57 89 44 95 50

Ta

ble

7

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by

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s b

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19

92

an

d 2

001.

‘Index

of

term

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index

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contr

actu

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th

an i

nv

estm

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VC

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igh

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in

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at

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tim

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g.

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the

age

of

the

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fir

m i

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ears

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ou

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sta

nd

ard

s’,

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dit

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pro

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ion

’, a

nd ‘

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ori

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rote

ctio

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(‘A

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are

fro

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l (1

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rou

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nti

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on

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bit

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ref.

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rd. p

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In

dust

ry &

yea

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s Y

es

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es

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es

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es

Y

es

Y

es

P

seu

do

R

2

0.5

1

0

.16

0.1

3

0

.27

0.2

1

0

.19

0.1

4

N

o .o

f ob

s.

127

103

109

107

111

127

127

C

. In

div

idual

rights

and s

pec

ific

inst

ituti

onal

contr

ols

F

irst

VC

round

-0.6

3

(0.1

4) *

**

-0.0

5

(0.1

4)

0.1

3

(0.1

0)

-0.2

2

(0.1

7)

-0.2

9

(0.3

3)

-0.2

0

(0.1

5)

-0.7

3

(0.2

9)*

*

Ag

e of

firm

-0

.12

(0

.03

)**

*

-0.0

6

(0.0

2)*

*

-0.0

1

(0.0

2)

0.0

0

(0.0

2)

-0.0

4

(0.0

4)

-0.0

7

(0.0

3)*

*

-0.0

7

(0.0

4)*

*

L

ex M

un

di

m

easu

re

0.2

1

(0.2

0)

0.2

1

(0.1

1) *

-0

.03

(0

.22

) -0

.23

(0

.18

) -0

.03

(0

.43

) 0

.08

(0

.11

) 0

.59

(0

.49

) A

ccoun

tin

g s

tan

d.

0.0

0

(0.0

1)

0.0

3

(0.0

1)*

**

-0.0

1

(0.0

1)

-0.0

1

(0.0

1)

0.0

3

(0.0

3)

-0.0

1

(0.0

1)

-0.0

1

(0.0

3)

Cre

dit

or

Pro

t.

0.0

1

(0.0

6)

0.0

7

(0.0

4)

-0.0

3

(0.0

6)

0.0

3

(0.0

5)

0.3

0

(0.1

2) *

*

-0.0

1

(0.0

3)

-0.0

4

(0.1

0)

Min

ori

ty P

rot.

0

.01

(0

.05

) -0

.01

(0

.04

) 0

.05

(0

.06

) -0

.04

(0

.06

) -0

.39

(0

.14

) **

*

0.0

3

(0.0

4)

0.0

1

(0.1

3)

Op

tion

tax

low

-0

.26

(0

.37

) -0

.44

(0

.30

) 0

.06

(0

.28

) -0

.47

(0

.28

)*

-0.1

9

(0.6

2)

0.0

9

(0.2

1)

-0.3

4

(0.5

5)

L

ead

VC

is

bas

ed i

n U

S

0.7

3

(0.0

7) *

**

0.3

3

(0.2

5)

0.1

3

(0.2

3)

0.5

3

(0.0

9)*

**

2.3

7

(0.6

0)*

**

0.1

9

(0.1

9)

1.1

0

(0.4

8)*

*

No

n-U

.S.

lead

VC

wit

h U

.S.

syn

dic

atio

n e

xp

erie

nce

0

.68

(0

.11

)**

*

0.3

6

(0.1

1)*

**

0.2

0

(0.1

3)

0.4

3

(0.1

0)*

**

1.6

4

(0.3

8)*

**

0.2

0

(0.0

9)*

*

0.4

9

(0.3

1)

In

dust

ry &

yea

r ef

fect

s Y

es

Y

es

Y

es

Y

es

Y

es

Y

es

Y

es

P

seu

do

R

2

0.4

9

0

.27

0.1

1

0

.29

0.2

5

0

.22

0.1

7

N

o .o

f ob

s.

108

90

93

91

95

108

108

Ta

ble

8

Lea

d V

C c

on

tract

s an

d s

urv

ival

Surv

ival

and f

ailu

re

stat

isti

cs f

or

70 l

ead V

Cs

from

18 c

ountr

ies

mak

ing i

nves

tmen

ts b

etw

een 1

992 a

nd 2

001.

Fai

lure

rat

e is

th

e p

erce

nta

ge

of

the

VC

fu

nd

s th

at h

ad

close

d d

ow

n o

r bee

n a

cquir

ed b

y A

ugust

1, 200

3. L

ead

VC

is

def

ined

as

the

VC

fu

nd

pro

vid

ing t

he

larg

est

amount

of

finan

cing i

n a

giv

en f

inan

cin

g r

ou

nd

. S

urv

ival

an

d f

ailu

re s

tatu

s w

as d

eter

min

ed f

rom

Ven

ture

Eco

no

mic

s, V

entu

reO

ne,

an

d V

C f

irm

web

site

s. P

refe

rred

sto

ck r

epre

sen

ts t

he

use

of

conver

tible

or

par

tici

pat

ing

pre

ferr

ed s

tock

.

Ch

i sq

uar

e te

sts

of

dif

fere

nce

in

fai

lure

rat

es a

re s

ign

ific

antl

y d

iffe

ren

t at

th

e 1

% *

**

; 5

% *

*,

and

10

% *

lev

els.

Nu

mb

er o

f L

ead

VC

s in

sam

ple

N

um

ber

of

VC

s fa

iled

or

no l

on

ger

in

dep

end

ent

by A

ug

ust

1 2

00

3

Fai

lure

rat

e, %

Acr

oss

all

leg

al r

egim

es

All

Lea

d V

Cs

70

11

16%

V

Cs

alw

ays

usi

ng

pre

ferr

ed

37

0

0%

V

Cs

som

etim

es u

sin

g p

refe

rred

4

1

2

5%

V

Cs

nev

er u

sin

g p

refe

rred

2

9

10

3

4%

Ch

i sq

uar

e te

st (

2 d

f) =

14

.87

**

*

Non

-co

mm

on

law

VC

s o

nly

All

Lea

d V

Cs

40

10

30%

V

Cs

usi

ng

all

pre

ferr

ed

14

0

0%

V

Cs

som

etim

es u

sin

g p

refe

rred

3

1

3

3%

V

Cs

nev

er u

sin

g p

refe

rred

2

3

9

39

%

Ch

i sq

uar

e te

st (

2 d

f) =

7.2

3 *

*

Co

mm

on

law

VC

s o

nly

All

Lea

d V

Cs

30

1

3%

V

Cs

usi

ng

all

pre

ferr

ed

23

0

0%

V

Cs

som

etim

es u

sin

g p

refe

rred

1

0

0%

V

Cs

nev

er u

sin

g p

refe

rred

6

1

1

7%

Ch

i sq

uar

e te

st (

2 d

f) =

4.1

4

Ta

ble

9

Lea

d V

C c

on

tra

cts

an

d s

urv

iva

l: M

ult

iva

ria

te a

na

lysi

s

Pro

bit

reg

ress

ion

s o

n t

he

lik

elih

oo

d o

f le

ad V

C s

urv

ival

fo

r 7

0 l

ead

VC

s fr

om

18

co

untr

ies

mak

ing

in

ves

tmen

ts b

etw

een

19

92

an

d 2

00

1.

Th

e d

epen

den

t v

aria

ble

tak

es

the

val

ue

of

one

if t

he

VC

fu

nd

had

no

t cl

ose

d d

ow

n o

r b

een

acq

uir

ed b

y A

ugu

st 1

, 20

03. ‘

Cap

tiv

e /

corp

ora

te V

C f

und

’ is

a d

um

my t

akin

g t

he

val

ue

of

on

e if

th

e V

C

fund w

as a

subsi

dia

ry o

f a

corp

ora

tion o

r fi

nan

cial

inst

ituti

on.

Surv

ival

and f

ailu

re s

tatu

s an

d l

ead

VC

fund c

har

acte

rist

ics

wer

e d

eter

min

ed f

rom

Ven

ture

Eco

no

mic

s,

Ven

ture

On

e, a

nd

VC

fir

m w

ebsi

tes.

Pre

ferr

ed s

tock

rep

rese

nts

th

e u

se o

f co

nv

erti

ble

or

par

tici

pat

ing

pre

ferr

ed s

tock

. ‘

Av

erag

e U

.S.

con

trac

t te

rm i

nd

ex f

or

VC

when

le

ad i

nves

tor’

is

the

aver

age

of

an i

ndex

of

U.S

.-st

yle

contr

actu

al t

erm

s ac

ross

all

th

e in

ves

tmen

ts i

n o

ur

sam

ple

wher

e th

e V

C w

as t

he

lead

in

ves

tor.

Th

e in

dex

is

calc

ula

ted

as

the

sum

of

the

du

mm

y v

aria

ble

s fo

r th

e p

rese

nce

of

mil

esto

nes

, ves

ting, V

C a

nti

-dil

uti

on p

rovis

ions,

V

C l

iquid

atio

n p

refe

rence

equal

to o

r gre

ater

th

an

inves

tmen

t, V

C r

edem

pti

on r

ights

, an

d V

C b

oar

d c

on

tro

l. C

oef

fici

ents

are

mar

gin

al e

ffec

ts.

Robust

Whit

e (1

98

0)

stan

dar

d e

rro

rs a

re p

aren

thes

es. R

egre

ssio

n

coef

fici

ents

are

sig

nif

ican

tly d

iffe

rent

fro

m z

ero a

t th

e 1

% *

**

; 5

% *

*,

and

10

% *

lev

els.

VC

alw

ays

use

d c

onv

erti

ble

p

refe

rred

as

lead

in

ves

tor

0.3

5

(0.0

9) *

**

0.2

5

(0.1

1)*

*

Av

erag

e U

.S.

con

trac

t te

rm i

nd

ex

for

VC

wh

en l

ead

in

ves

tor

0.0

9

(0.0

3) *

**

0.0

4

(0.0

2)*

Ear

ly s

tag

e fu

nd

fo

cus

-0.0

8

(0.1

0)

-0.0

4

(0.0

9)

Cap

tiv

e /

corp

ora

te V

C f

und

-0.1

3

(0.1

3)

-0.0

6

(0.0

9)

VC

in c

om

mo

n l

aw c

oun

try

-0.0

1

(0.0

7)

-0.0

7

(0.0

6)

Lo

g V

C s

ize

($M

)

0

.03

(0

.02

)

0

.04

(0

.02

) **

P

seu

do

R

2

0.2

5

0

.36

0.2

1

0

.43

No .o

f ob

s.

69

63

55

51

Ta

ble

10

Rel

ati

on

ship

bet

wee

n v

alu

ati

on

s an

d U

.S.-

style

co

ntr

act

ing

Su

mm

ary i

nfo

rmat

ion

fo

r 145 i

nv

estm

ents

in

10

7 p

ort

foli

o c

om

pan

ies

from

18

cou

ntr

ies

by 6

9 d

iffe

rent

lead

VC

s b

etw

een 1

99

2 a

nd 2

001

. ‘L

n P

re-m

on

ey’

is t

he

log

arit

hm

o

f th

e p

re-m

oney

val

uat

ion.

‘VC

equit

y %

’ is

the

per

centa

ge

of

the

firm

s fu

lly d

ilute

d r

esid

ual

cas

h-f

low

rig

hts

all

oca

ted t

o a

ll t

he

VC

s in

ves

tin

g i

n t

he

com

pan

y,

assu

min

g

that

all

per

form

ance

mil

esto

nes

are

met

an

d a

ll f

ou

nd

er a

nd

em

plo

yee

eq

uit

y h

as v

este

d.

‘In

dex

of

term

s’ i

s an

in

dex

of

U.S

.-st

yle

contr

actu

al t

erm

s an

d i

s ca

lcula

ted a

s th

e su

m o

f th

e dum

my v

aria

ble

s fo

r th

e pre

sence

of

mil

esto

nes

, ves

ting,

VC

anti

-dil

uti

on

pro

vis

ion

s,

VC

liq

uid

atio

n p

refe

ren

ce e

qual

to o

r gre

ater

than

in

ves

tmen

t, V

C

red

emp

tio

n r

igh

ts,

and

VC

bo

ard

co

ntr

ol.

‘F

irst

VC

ro

un

d’

is a

du

mm

y e

qu

al t

o o

ne

if t

he

inves

tmen

t re

fers

to t

he

firs

t ro

und w

her

e an

y V

C i

nv

este

d. ‘R

ou

nd

’ is

th

e n

um

ber

o

f V

C i

nv

estm

ent

rou

nd

s th

e p

ort

foli

o c

om

pan

y h

as r

ecei

ved

, in

clu

din

g t

he

curr

ent

rou

nd

. ‘

Ag

e o

f fi

rm’

is t

he

age

of

the

po

rtfo

lio c

om

pan

y a

t th

e ti

me

of

the

inv

estm

ent,

in

yea

rs.

‘Com

mon l

aw’

is a

dum

my e

qual

to o

ne

if t

he

port

foli

o c

om

pan

y i

s lo

cate

d i

n a

countr

y w

ith a

com

mon l

aw l

egal

syst

em.

‘Lea

d V

C h

as U

S e

xp

erie

nce

’ is

a d

um

my

eq

ual

to

on

e if

th

e le

ad V

C h

as p

rev

iou

sly

inv

este

d i

n a

co

mp

any

wit

h U

S-b

ased

VC

fun

ds

as c

o-i

nv

esto

rs.

‘VC

is

bas

ed i

n t

he

US

’ is

a d

um

my e

qual

to o

ne

if t

he

Lea

d V

C

inv

esto

r is

lo

cate

d i

n t

he

Un

ited

Sta

tes.

‘N

on

-U.S

. V

C w

ith

U.S

. ex

per

’ is

a d

um

my e

qu

al t

o o

ne

if t

he

Lea

d V

C i

nv

esto

r is

(1

) n

ot

loca

ted

in

th

e U

nit

ed S

tate

s, a

nd

(2

) h

ad

eith

er p

revio

usl

y i

nves

ted i

n a

po

rtfo

lio c

om

pan

y l

oca

ted i

n t

he

Unit

ed S

tate

s or

co-i

nves

ted w

ith a

U.S

.-bas

ed V

C a

t th

e ti

me

of

the

fin

anci

ng

. ‘

Lo

g D

eal

Siz

e’ i

s th

e lo

gar

ith

m o

f V

C f

inan

cin

g c

om

mit

ted

in

th

e ro

un

d,

mea

sure

d i

n m

illi

on

US

D.

Ind

ust

ry e

ffec

ts i

ncl

ud

e d

um

mie

s fo

r 5

in

du

stri

es:

Inte

rnet

/So

ftw

are,

Hig

h-t

ech

/Har

dw

are,

T

elec

om

, M

edic

al,

Oth

er.

Reg

ress

ion c

oef

fici

ents

are

sig

nif

ican

tly d

iffe

ren

t fr

om

zer

o a

t th

e 1

% *

**

; 5

% *

*, an

d 1

0%

* l

evel

s.

L

n P

re-m

on

ey

Ln

Pre

-mo

ney

L

n P

re-m

on

ey

VC

eq

uit

y %

V

C e

qu

ity

%

VC

eq

uit

y %

F

irst

VC

round

-1.0

9

(0.3

0) *

**

-1.1

6

(0.3

3)*

**

-0.6

5

(0.2

7)*

*

0.5

9

(5.9

6)

1.0

8

(5.7

7)

3.6

3

(5.7

0)

Ro

und

0

.06

(0

.22

) -0

.04

(0

.23

) -0

.10

(0

.19

) 1

3.4

2

(4.4

9)*

**

15.0

5

(4.1

8)*

**

12.4

6

(4.1

9)*

**

Ag

e of

firm

-0

.01

(0

.03

) 0

.00

(0

.03

) 0

.01

(0

.03

) -0

.81

(0

.42

) *

-0.8

5

(0.4

1)*

*

-0.7

0

(0.3

7)*

C

om

mo

n l

aw

0.7

3

(0.3

6)*

*

0.6

3

(0.3

3)*

0

.41

(0

.26

) -4

.32

(4

.77

) -4

.26

(5

.02

) -7

.21

(4

.48

)

Ind

ex

0.0

3

(0.0

7)

-0.0

6

(0.1

0)

-0.1

5

(0.0

7) *

3

.48

(1

.66

)**

3.7

3

(1.9

6)*

2

.36

(1

.63

)

Lea

d V

C i

s b

ased

in U

S

0.8

7

(0.5

4)

-0.0

3

(0.0

8)

No

n-U

.S.

lead

VC

wit

h U

.S.

syn

dic

atio

n e

xper

ien

ce

0.4

0

(0.4

3)

-0.0

4

(0.0

5)

L

og

Dea

l si

ze

0.6

8

(0.1

0) *

**

0.0

5

(0.0

2)*

*

Ind

ust

ry &

yea

r ef

fect

s Y

es

Y

es

Y

es

Y

es

Y

es

Y

es

A

dju

sted

R

2

0.2

2

0

.22

0.5

6

0

.32

0.3

4

0

.38

No .o

f ob

s.

99

97

98

94

92

93

SIFR Research Report Series

All reports can be downloaded from our website www.sifr.org, under the heading Re-search. Reports no. 1-15 are also available in print. In order to obtain copies of printedreports, please send your request to info@sifr.org with detailed ordering information.

1. Foreigners’ Trading and Price Effects Across FirmsMagnus Dahlquist and Goran Robertsson, December 2001

2. Hedging Housing RiskPeter Englund, Min Hwang, and John M. Quigley, December 2001

3. Winner’s Curse in Discriminatory Price Auctions: Evidence from theNorwegian Treasury Bill AuctionsGeir Høidal Bjønnes, December 2001

4. U.S. Exchange Rates and Currency FlowsDagfinn Rime, December 2001

5. Reputation and Interdealer Trading. A Microstructure Analysis of theTreasury Bond MarketMassimo Massa and Andrei Simonov, December 2001

6. Term Structures in the Office Rental Market in StockholmAke Gunnelin and Bo Soderberg, April 2002

7. What Factors Determine International Real Estate Security Returns?Foort Hamelink and Martin Hoesli, September 2002

8. Expropriation Risk and Return in Global Equity MarketsRavi Bansal and Magnus Dahlquist, November 2002

9. The Euro Is Good After All: Corporate EvidenceArturo Bris, Yrjo Koskinen, and Mattias Nilsson, November 2002

10. Which Investors Fear Expropriation? Evidence from Investors’ Stock PickingMariassunta Giannetti and Andrei Simonov, November 2002

11. Corporate Governance and the Home BiasMagnus Dahlquist, Lee Pinkowitz, Rene M. Stulz, and Rohan Williamson,November 2002

12. Implicit Forward Rents as Predictors of Future RentsPeter Englund, Ake Gunnelin, Martin Hoesli, and Bo Soderberg,November 2002

13. Accounting Anomalies and Information UncertaintyJennifer Francis, Ryan LaFond, Per Olsson, and Katherine Schipper, June 2003

14. Characteristics, Contracts and Actions: Evidence From VentureCapitalist AnalysesSteven N. Kaplan and Per Stromberg, June 2003

15. Valuing Corporate LiabilitiesJan Ericsson and Joel Reneby, June 2003

16. Rental Expectations and the Term Structure of Lease RatesEric Clapham and Ake Gunnelin, October 2003

17. Dealer Behavior and Trading Systems in Foreign Exchange MarketsGeir Høidal Bjønnes and Dagfinn Rime, December 2003

18. C-CAPM and the Cross-Section of Sharpe RatiosPaul Soderlind, December 2003

19. Is there Evidence of Pessimism and Doubt in Subjective Distributions?A Comment on AbelPaolo Giordani and Paul Soderlind, December 2003

20. One for the Gain, Three for the LossAnders E. S. Anderson, May 2004

21. Hedging, Familiarity and Portfolio ChoiceMassimo Massa and Andrei Simonov, May 2004

22. The Market Pricing of Accruals QualityJennifer Francis, Ryan LaFond, Per Olsson, and Katherine Schipper, May 2004

23. Privatization and Stock Market LiquidityBernardo Bortolotti, Frank de Jong, Giovanna Nicodano, and Ibolya Schindele,June 2004

24. Pseudo Market Timing: Fact or Fiction?Magnus Dahlquist and Frank de Jong, June 2004

25. All Guts, No Glory: Trading and Diversification among Online InvestorsAnders E. S. Anderson, June 2004

26. The Evolution of Security DesignsThomas H. Noe, Michael J. Rebello, and Jun Wang, September 2004

27. The Credit Cycle and the Business Cycle: New Findings Using the Loan OfficerOpinion SurveyCara Lown and Donald P. Morgan, September 2004

28. How Do Legal Differences and Learning Affect Financial Contracts?Steven N. Kaplan, Frederic Martel, and Per Stromberg, September 2004

Stockholm Institute for Financial Research